How Microeconomic Principles Affect Business Decisions

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

This lesson explains how microeconomic principles affect the decision-making processes of businesses. Examples will illustrate how these principles impact labor, productivity, the types of goods and services offered, supply and demand, economic utility, and pricing.

Making Economical Business Decisions

Because goods and services are limited, a producer needs to know what to produce, who to produce for, and how to produce given scarce resources. These business decisions are vital to making a profit, and economics is a way for businesses to use theories of human behavior to predict what is best for their business.

Economics is divided into two fields: macroeconomics and microeconomics. This lesson addresses microeconomics and how it affects business decisions.

What is Microeconomics?

Microeconomics looks at the behavior of individuals and firms when making decisions given scarce resources. The goal in microeconomics is to understand the behavior of individual units (i.e. businesses and consumers) enough to predict success.

Businesses, in particular, use microeconomic principles to make decisions regarding the following factors: labor, productivity, types of goods and services offered, supply and demand, economic utility, and pricing.

Labor Decisions

Individual businesses demand labor, and this demand is heavily influenced by wages. Wages are what businesses pay workers, and this includes fringe benefits like vacation time, insurance, and professional development. Businesses must decide how many labor hours to demand given certain wages.

Microeconomic principles tell us that, all other things being equal, as wages increase businesses demand less labor.

• For example, say widgets are produced at a wage of $15 per hour. As that wage increases to $20, a business will reduce the number of labor hours demanded. All other factors remaining the same, a business only has so much money budgeted for labor hours.

Productivity Decisions

Productivity is defined as the output of a good or service per time spent, such as the number of widgets produced in a labor-hour. Productivity is a function of the relationship between outputs and inputs, given the available technology.

Microeconomic principles tell us that businesses will set productivity at the highest level of economic efficiency, where the production for one good or service cannot be made better off without reducing production of another.

• For example, say 10,000 widgets are produced in an hour. If the production of widgets cannot be improved without reducing another output, the business is at maximum efficiency and this where productivity should remain.

Types of Goods and Services Offered

The types of goods and services offered by businesses are influenced by what consumers are willing to pay for them. As price increases for one good or service, businesses switch production to that good or service, often decreasing the production of less profitable types of goods and services.

Microeconomic principles tell us that all other things being equal, as the price of a good or service increases, businesses increase the supply of that good or service and decrease the supply of others.

• For example, say a widget costs $50 to purchase. If the price goes up and consumers start paying $75 for a lightweight widget, businesses will switch production to the lightweight widget. All other factors remaining the same, a business will increase production of the higher priced good or service (because it is more profitable for that business).

Supply and Demand Decisions

Supply decisions might seem to be controlled by businesses; however, demand increases when consumers agree to pay more for a good or service. These higher prices mean a businesses will increase production and provide more supply of the good or service.

Microeconomic principles tell us that, all other things being equal, as the price of a good or service increases, businesses will increase the supply of that good or service.

• For example, say a widget costs $50 to purchase. If consumers start paying $75 for the widget, businesses will increase production of the widget. All other factors remaining the same, a business will increase production of a good or service as price increases.

Economic Utility

Economic utility is the amount of satisfaction provided by consuming a good or service as compared to its alternatives. When the price of a good or service decreases, consumers have more utility and are likely to purchase more goods or services. When the price of a good increases, consumers have less utility available and may substitute another good or service.

Microeconomic principles tell us that businesses need to create goods and services that have high utilities because consumers will maximize their utility given their resources.

• For example, say a stainless steel widget costs $50 to purchase. If this price increases to $75 and consumers feel that this price is a fair estimation of utility, they will continue to purchase the stainless steel widgets and give up something else. However, if utility does not increase enough to compensate for the price change, consumers will switch to a substitute good, perhaps a widget made of plastic. Consumers do so because they only have so many resources available to maximize their utility.

Pricing Decisions

Because consumers have limited resources, prices of goods and services affect what they demand. As prices increase, consumers typically begin looking elsewhere for another good or service.

Microeconomic principles tell us that businesses need to find a price point that maximizes efficiency but does not drive consumers to alternatives.

• For example, say the price of a widget increases from $50 to $100. Consumers may refuse to pay for this increase and stop buying widgets altogether if they can find a substitute for the widget. Consumers may be willing, however, to pay $75 per widget without any shift in demand.

Lesson Summary

Using microeconomic principles to predict how consumers will behave is a key piece of the decision-making processes for businesses. These business decisions are vital to deciding how to offer goods and services.

How businesses use scarce resources affects important factors such as labor, productivity, types of goods and services offered, supply and demand, economic utility, and pricing. Microeconomics tells us how each factor reacts in the face of change.

Will consumers find a substitute? Will an increase in wages reduce the supply? How much utility do consumers gain? Microeconomics is pivotal in answering these questions and providing the foundation for predicting how the market will react.

Summary:

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